Samsung Electronics is considering production of a new cell phone. The project w

Question

Samsung Electronics is considering production of a new cell phone. The project will require an investment of $20 million and generate $8 million per year over the next 3 years. If the phone is well-received (good condition), the project will produce cash flows of $9 million a year for 3 years; but if the market does not like the product (bad condition), the cash flows will be only $5 million per year. There is a 50% probability of both good and bad market conditions. Samsung can delay the project two years while it conducts a test to determine whether demand will be strong or weak. The delay will not affect the project

Explanation / Answer

Calculation on Excel.....

Year 0

Year 1

Year 2

Year 3

Cash flows

$ (20,000,000.00)

$1,000,000.00

$1,000,000.00

$1,000,000.00

Present value factor @ 6%

1

0.94

0.89

0.84

Present value of cash flows

$(20,000,000.00)

$ 943,396.23

$ 889,996.44

$839,619.28

NPV= $(17,326,988.05)

Year 0

Year 1

Year 2

Year 3

Year 4

Cash flows

$--------  

$(20,000,000.00)

$1,000,000.00

$1,000,000.00

$1,000,000.00

Present value factor @ 6%

1

0.94

0.89

0.84

0.79

Present value of cash flows

$------  

$(18,867,924.53)

$ 889,996.44

$ 839,619.28

$ 792,093.66

NPV=$(16,346,215.14)

Year 0

Year 1

Year 2

Year 3

Year 4

Cash flows

$-----  

$(20,000,000.00)

$5,000,000.00

$5,000,000.00

$5,000,000.00

Present value factor @ 6%

1

0.94

0.89

0.84

0.79

Present value of cash flows

$----  

$(18,867,924.53)

$4,449,982.20

$4,198,096.42

$3,960,468.32

NPV=$(6,259,377.60)

a) What kind of real option does Samsung consider?

Solution-

The rule of NPV always prefers the investment with the higher positive NPV.

NPV=$(6,259,377.60)

b) What action do you recommend? Take it immediately or wait?

Solution-

We would recommend to Wait for an year and then begin the project only if the projected demand is strong as the NPV of the project in case the demand turn out to be week is negative.

Year 0

Year 1

Year 2

Year 3

Cash flows

$ (20,000,000.00)

$1,000,000.00

$1,000,000.00

$1,000,000.00

Present value factor @ 6%

1

0.94

0.89

0.84

Present value of cash flows

$(20,000,000.00)

$ 943,396.23

$ 889,996.44

$839,619.28

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